Why Temporary Fixes Aren’t Fixes at All

Jim Prevor

June 27, 2011 11:08 AM

Robert H. Frank, a professor of economics at Cornell University, makes an important point in his New York Times column, titled “The Payroll Tax Needs a Vacation.” Specifically, Frank argues, we shouldn’t allow the debate over the federal deficit to obscure the problem of getting people back to work.

As a matter of fact, these two problems are really flip sides of the same coin. It is highly unlikely that we will solve the deficit problem if we don’t grow the economy and get people back to work.

The solution Frank identifies as most promising – a limited payroll tax holiday through 2012 – would seem to have much to recommend it. By eliminating both the 6.2 percent of salary the employee gives up in social security taxes and the 6.2 percent that the employer pays on new hires, a payroll tax holiday would lower the cost of providing jobs and allow people to live on jobs that pay less than they needed previously. Both aspects would surely boost employment.

If one is Keynesian-minded, there is also a bonus in that all this extra money left in the pockets of people and businesses would amount to “stimulus” and boost aggregate demand – but that effect is not necessary to see this as boosting employment.

Certainly such a proposal is more likely to be successful than plans, also endorsed by Frank, to hire the unemployed to fix bridges and roads, since even President Obama has pointed out the difficulty of finding “shovel-ready” projects.

Yet we are already living in the midst of a partial payroll tax holiday with employee contributions reduced to 4.2 percent of salary for 2011, and its impact has been limited.

There is a lesson here for policymakers, if they are willing to pay attention. It is that macroeconomic models are imprecise and that the success of any economic policy depends, crucially, on the way businesspeople and entrepreneurs will react.

Unfortunately, most of those in a position to influence policy have no practical experience in business or creating jobs. As a result, they don’t really understand what will motivate action. Thus policymakers are frustrated; they honestly don’t understand why their trillion-dollar schemes aren’t producing the growth expected.

As an employer, although I would welcome any payroll tax relief for my company and our employees, a law such as Frank proposes would actually make me very careful about hiring.

Employee hiring and training is very expensive, and we really don’t want to hire anyone if we don’t think there is a decent shot they will be working for us in two years.

Terminating employees is also difficult and expensive and we try hard not to do things that could lead us to have to fire people. We often pay severance pay and wind up keeping people longer than we need to (for example, we try to not fire people in the weeks before Christmas). It also is demoralizing for fellow employees. Then there is the burden of COBRA paperwork and pension rollovers. There is the ever present possibility that a terminated employee will sue.

Yet this plan seems to set us up either to experience dramatically increased cost of employment on January 1, 2013, or to lose lots of employees.

Obviously, the fact that we will have to start paying 6.2 percent on January 1, 2013 right away makes me hesitant. If I don’t think the workers are worth that price now, I wouldn’t sign an agreement with the workers promising to give an automatic payroll increase of 6.2% in the future. Yet that is practical the implication is of Frank’s proposal. It would make me instantly want to underpay any new employees so that I could be ready to give them this raise that would be required by law when the payroll “tax holiday” is over.

Yet the issue goes beyond the employer-paid 6.2 percent. Like it or not, in business the problems of the employees are the problems of management, and if we don’t withhold the 6.2 percent contribution required under law for the next year and a half and then start withholding it on January 1, 2013, my office will be filled with employees pleading for a raise. A very small percentage of employees may bankroll a temporary payroll tax holiday or use it to pay down debt, but for most, it will become part of their income and they will respond to the re-imposition of the tax as if I gave them a pay cut.

In other words, like a drug-induced high, with a low sure to follow, this proposal is a disaster waiting to happen. It promises a short-term interlude, followed by a day of reckoning. We probably can’t afford to give everyone a big raise on January 1, 2013, and we don’t want the morale problems, the expense and the hassles that come with firing people. So we won’t rush to hire. If prudent businesspeople will hold back, this means the policy will never produce the bang for the buck predicted in the macroeconomic models…or by Professor Frank.

There is another problem with a policy proposal such as this. Its manifest unfairness will scare many businesspeople into thinking they better hold onto their money. Why is it unfair? Most of the time, we speak about the political process protecting existing companies and interest groups. Yet, in this case, a decision to exempt new hires but not existing employees from the employer contribution to social security is a decision to advantage new or fast growing competitors over existing businesses.

Professor Frank is not very specific on this proposal. Presumably the plan would exempt companies from paying payroll taxes on hires above an existing base number to prevent companies from firing people so as to hire new employees cheaper.

Yet this kind of plan would mean that a solid business, say a local store that has 10 longtime employees, could be thrust into competition with a start-up or expanding business that gets a big advantage on labor costs. There is no reason the government should want this long-established store to close just so some newcomer can open across the street.

One wishes there was some indication that Professor Frank or policymakers who push these macroeconomic modeled programs had thought at all about the way an entrepreneur, confronted with the prospect of his business being disadvantaged by such a federal policy, could easily come to the conclusion that his goal should be to stop reinvesting, not to start new ventures, and to pull out money where he can. A whole society can come to start thinking that government policy is too arbitrary and that it makes building a business too risky.

Thus the all too clever machinations of brilliant policymakers can purchase a little short-term stimulus at the cost of the death of American entrepreneurialism. And the oh-so-smart experts, who know little of human motivation and fear, will stand befuddled wondering why the model didn’t work.